By Daniel Stelter, Harvard Business Review
A downturn opens up rare opportunities to outmaneuver rivals. But first you need to put your own house in order.
Inaction is the riskiest response to the uncertainties of an economic crisis. But rash or scattershot action can be nearly as damaging. Rising anxiety (how much worse are things likely to get? how long is this going to last?) and the growing pressure to do something often produces a variety of uncoordinated moves that target the wrong problem or overshoot the right one. A disorganized response can also generate a sense of panic in an organization. And that will distract people from seeing something crucially important: the hidden but significant opportunities nestled among the bad economic news.
We offer here a rapid but measured approach–simultaneously defensive and offensive–to tackling the challenges posed by a downturn. Many companies are already engaged in some kind of exercise like this. Certainly every organization with an institutional pulse has held discussions focusing on what it should do about the current economic crisis. We hope this article will help you move from what may have been ad hoc conversations and initiatives to a carefully thought-out plan.
The merits of a comprehensive and aggressive approach are borne out in research by the Boston Consulting Group, which indicates that companies whose early responses to a downturn are tentative (for example, modest belt-tightening) typically overreact later on (say, cutting costs more than they ultimately need to). This results in an expensive recovery for the company when the economy rebounds.
Our approach has two main objectives, from which a series of action items devolves. First, stabilize your business, protecting it from downside risk and ensuring that it has the liquidity necessary to weather the crisis. Then, and only then, can you identify ways to capitalize on the downturn in the longer term, partly by exploiting the mistakes of less savvy rivals.
For some companies, the outcome of this process will be a program of immediate actions that represent a turbocharged version of business as usual. For others, it will be a painful realization that nothing short of an urgent corporate turnaround will suffice.
What Is Your Exposure?
The first step for a company to take in a challenging economic environment–especially one that could significantly worsen–is to assess in a systematic manner its own vulnerabilities, at the company level and by business unit.
Consider several scenarios.
As an economic crisis evolves, sketch out at least three scenarios–a modest downturn, a more severe recession, and a full-blown depression, as defined by both duration and severity. Consider which scenario is most likely to unfold in your industry and your business, based on available data and analysis. There was evidence from the beginning, for example, that the current global downturn truly stands apart. Early on, banking losses had outstripped those of recent financial disasters, including the United States savings and loan crisis (1986—1995), the Japanese banking crisis (1990—1999), and the Asian financial crisis (1998—1999). Furthermore, as the economy first began to stall, the underlying problem of consumer and corporate indebtedness–in the United States, it totaled about 380% of GDP, nearly two and a half times the level at the beginning of the Great Depression–pointed to a prolonged period of economic pain.
Next, determine the ways in which each of the scenarios might affect your business. How would consumers’ limited capacity to borrow reduce demand for your products? Will job insecurity and deflating asset prices make even the creditworthy increasingly reluctant to take on more debt? Will reduced demand affect your ability to secure short-term financing, or will weak stock markets make it difficult to raise equity? Even if you are able to tap the debt and equity markets, will higher borrowing costs and return requirements raise your cost of capital?
Quantify the impact on your business.
Run simulations for each of these scenarios that generate financial outcomes on the basis of major variables, including sales volume, prices, and variable costs. Be sure to confront head on what you see as the worst case. For example, what effect would a 20% decline in sales volume and a 5% decline in prices have on your overall financial performance? You may be surprised to find out that, even in the case of a still-healthy company with operating margins (before interest and taxes) of around 10%, such a decline in volume and prices could turn current profits into huge losses and send cash flow deep into the red. Conduct a similar analysis for each business unit.
Next, quantify how your balance sheet might be affected under the different scenarios. For example, what will the impact be of asset price deflation? To what extent might lower cash flows and the higher cost of capital affect goodwill and require write-offs on past acquisitions? Will falling commodity prices cushion some of the detrimental effects?
Assess rivals’ vulnerabilities.
Of course, none of this process should be carried out in a vacuum. Your industry and the locations of your operations around the world will help determine how your business will be affected. It’s critical to understand your own strengths and weaknesses relative to those of your competitors. They will have different cost structures, financial positions, sourcing strategies, product mixes, customer focuses, and so on. To emerge from the downturn in a lead position, you must calibrate the actions you plan to take in light of the actions that your competitors will most likely take. For example, assess potential acquisitions with a focus on vulnerable customer groups of weaker competitors.
This assessment of different scenarios and their effects on your company and its rivals, while just a first step, will help you identify particular areas where you’re vulnerable and where action is most immediately needed. This analysis will also help you to communicate to the entire organization the justification and the motivation for actions you’ll need to take in response to the crisis.
How Can You Reduce Your Exposure?
Once you understand how your business could be affected, you need to figure out the best way to survive and maximize your company’s performance during the downturn. This requires achieving several broad objectives.
Protect the existing business.
After ensuring that the company is on a firm financial footing, turn to protecting the viability of the business. You must be prepared to act quickly and decisively to improve core operations.
Begin with aggressive moves to reduce costs and increase efficiency. Although cost-cutting is the first thing most companies think about, their actions are often tentative and conservative. You need to work rapidly to implement measures, using the turbulent economic environment to catalyze action that is long overdue–or to revive earlier initiatives that proved too controversial to fully implement in good times. Keep in mind, though, that while speed is important so is a well-reasoned plan: You don’t want to make cuts that in the long term will hurt more than they help by, for example, putting important future business opportunities at risk.
Some means of streamlining the organization and lowering break-even points are obvious: stripping out layers of the organizational hierarchy to reduce head count, consolidating or centralizing key functions, discontinuing long-standing but low-value-added activities. SG&A expenses–selling, general, and administrative costs, such as marketing–are also prime targets for cost-cutting. As such, they can highlight the risks of purely reactive action: Companies that injudiciously slash marketing spending often find that they later must spend far more than they saved in order to recover from their prolonged absence from the media landscape.
Opportunities to reduce materials and supply chain costs also arise in a downturn. Now is the time to pursue a comprehensive review of your current suppliers and procurement practices, which undoubtedly will prompt new initiatives–the adoption of a demand management system, say, or the standardization of components. In particular, consider how the downturn affects the economic equation of offshore manufacturing. Falling shipping costs could make offshoring more attractive, even for low-cost items; at the same time, a weakening domestic currency, trade barriers, and especially the cash tied up in the additional working capital required to source a product far from its market may offset any savings.
While looking for opportunities to reduce spending, you’ll also want to aggressively manage the top line, cash being crucially important in a recession. Actively work both to protect existing revenue and identify ways to generate additional revenue from your current business. Customer retention initiatives become more valuable than ever. Consider tactical changes in sales force utilization and incentives. Reallocate marketing spending to bolster immediate revenue generation rather than longer-term brand building. While granting trade credit sparingly, also consider the possible benefits of offering customers more-generous financial terms while charging them higher prices–provided you’ve done your homework on your own financial structure.
As these initiatives suggest, you’ll want to rethink your product mix and pricing strategies in response to shifting customer needs. Purchasing behavior changes dramatically in a recession. Consumers increasingly opt for lower-priced alternatives to their usual purchases, trading down to buy private label products or to shop at discount retailers. Although some consumers will continue to trade up, they’ll do so in smaller numbers and in fewer categories. Consumer products companies should consider offering low-priced versions of popular products–think of the McDonald’s Dollar Menu in the United States or Danone’s Eco-Pack yogurt in France. Whatever your business, determine how the needs, preferences, and spending patterns of your customers, whether consumer or corporate, are affected by the economic climate. For example, careful segmentation may reveal products primarily purchased by people still willing to pay full price. Use that intelligence to inform product portfolio and investment choices.
Innovative pricing strategies may also alleviate downward pressure on revenue. These include: results-based pricing, a concept pioneered by consulting firms that links payment to measurable customer benefits resulting from use of a product or service; changes in the pricing basis that would allow a customer to, for example, rent equipment by the hour rather than by the day; subscription pricing, by which a customer purchases use of a product–say, a machine tool–rather than the product itself; and the unbundling of a service so that customers pay separately for different elements of what was previously an all-in-one package, as airlines have done with checked baggage and in-flight meals and entertainment. Offering consumers new and creative customer financing packages could tip the balance in favor of a sale. It was during the Great Depression, after all, that GE developed its innovative strategy of financing customers’ refrigerator purchases.
You should definitely rein in your investment program. Most developed economies had excess capacity even before the downturn: Capacity utilization in the United States, for example, fell below 80% of potential output beginning in April 2008. In the current economy, there is even less need, in most industries, to invest in further capacity. You need to establish stringent capital allocation guidelines aligned with the current economic climate, if you haven’t already. This may also be the time to shed unproductive assets, including manufacturing plants that have previously been difficult to shut down, selling them where possible to generate cash for the business.
Finally, take this opportunity to divest noncore businesses, selling off peripheral or poorly performing operations. Don’t wait for better times, in the hope of getting a price that matches those of recent years, when the economy was buoyant and credit was plentiful. Those conditions aren’t likely to return anytime soon, and if the business isn’t critical to your activities and increases your vulnerability to the downturn, divest it now.
Research by our firm shows a strongly positive market reaction to the right divestitures in recessionary times. And shedding noncore operations ideally will end up energizing your core business. In 2003, in the middle of a particularly acute economic downturn in Germany, MG Technologies, a €6.4 billion engineering and chemicals company, decided to focus on its specialty mechanical engineering business. It sold its noncore chemical and plant engineering businesses and emerged as the renamed GEA Group, a slimmed down but successful specialty process engineering and equipment company, better positioned to pursue growth opportunities in its core areas.
Maximize your valuation relative to rivals.
Your company’s share price, like that of most firms, will take a beating during a downturn. While you may not be able to prevent it from dropping in absolute terms, you want it to remain strong compared with others in your industry. Much of what you’ve done to protect the financial fundamentals of your business will serve you well. In a downturn, our data shows that markets typically reward a strong balance sheet with low debt levels and secured access to capital. Instead of being punished by activist investors and becoming a takeover target for hedge funds, a company sitting on a pile of cash is viewed positively by investors as a stable investment with lower perceived risk. For that to happen, you need to create a compelling investor communications strategy that highlights such drivers of relative valuation. This will also be important as you try to capitalize on the competitive opportunities that a recession offers, such as seeking attractive mergers and acquisitions.
You can further enhance your relative value if you reassess your dividend policy and share buyback plans. A Boston Consulting Group study of U.S. public companies found that, on average, investors favor dividends because they represent a much stronger financial commitment to investors than buybacks, which can be stopped at any time without serious consequences. On average, sustained dividend increases of 25% or more overwhelmingly resulted in higher relative valuation multiples in the two quarters following their announcement. By contrast, buybacks had almost no impact on the relative valuation multiple in the two quarters following the transaction. For example, TJX Companies, a U.S. discount retailer, announced a dividend increase of 33% in June 2002, when the country was in a recession–and then enjoyed a price-to-earnings multiple 42% higher than the average of S&P 500 companies over the two quarters following the announcement. These are exceptional times, though, and we recommend that companies analyze their particular situation as well as investor preferences before taking a specific measure.
How Can You Gain Long-Term Advantage?
The best companies do more than survive a downturn. They position themselves to thrive during the subsequent upturn, guided again by a number of broad objectives.
Invest for the future.
Investments made today in areas such as product development and information or production technology will, in many cases, bear fruit only after the recession is past. Waiting to move forward with such investments may compromise your ability to capitalize on opportunities when the economy rebounds. And the cost of these investments will be lower now, as competition for resources slackens.
Given current financial constraints, you won’t be able to do everything, of course, or even most things. But that shouldn’t keep you from making some big bets. Prioritize the different options, protecting investments likely to have a major impact on the long-term health of the company, delaying ones with less-certain positive outcomes, and ditching those projects that would be nice to have but aren’t crucial to future success.
Sanofi-Synthélabo, the French pharmaceutical company, entered the economic recession that began in 2001 with a solid product portfolio. Throughout the downturn, the company maintained, and in some cases increased, its R&D spending in order to keep its product pipeline robust. Sanofi increased its absolute R&D expenditure from €950 million in 2000 to €1.3 billion in 2003. Because of its strong business and financial performance, the company gained market share and outperformed peers in the stock market. The company was thus well positioned to acquire Aventis, a much larger Franco-German pharmaceutical company, after a takeover battle, in the economic upswing of 2004.
Or look at Apple Computer. The company wasn’t in particularly good shape as it headed into the 2001—2003 recession. For one thing, revenue fell 33% in 2001 over the previous year. Nonetheless, Apple increased its R&D expenditures by 13% in 2001–to roughly 8% of sales from less than 5% in 2000–and maintained that level in the following two years. The result: Apple introduced the iTunes music store and software in 2003 and the iPod Mini and the iPod Photo in 2004, setting off a period of rapid growth for the company.
A downturn is also a good time to invest in people–for example, to upgrade the quality of your management teams. Competition for top people will be less fierce, availability higher, and the cost correspondingly lower.
Pursue opportunistic and transformative M&A.
The recession will change several of the long-standing rules of the game in many industries. Exploit your competitors’ vulnerabilities to redefine your industry through consolidation. History shows that the best deals are made in downturns. According to research by our firm, downturn mergers generate about 15% more value, as measured by total shareholder return, than boom-time mergers, which on average exhibit negative TSR.
To capitalize on opportunities, closely monitor the financial and operational health of your competitors. Companies lacking the financial cushion to benefit from the recession–or even to stay afloat–may even welcome your advances.
In late 2001, only weeks after the 9/11 terrorist attacks had brought vacation travel to a near standstill, Carnival, the world’s largest cruise ship operator, interceded in the planned friendly merger of Royal Caribbean and P&O Princess Cruises, then the second and third largest cruise operations respectively. Its own bid to acquire P&O Princess required persistence–it was 15 months before P&O Princess shareholders finally accepted Carnival’s offer–but the deal turned out to be a smart strategic move for the company, whose total shareholder returns far surpassed those of the S&P 500 in the years following the announcement and then the completion of the acquisition.
Of course, you’ll have to ride out the recession carrying the baggage of any company you acquire, so due diligence–particularly concerning a potential target’s current and future cash positions–takes on even more importance during a downturn. This knowledge will help you to limit the particular risks arising from an acquisition made during a recession, as well as to convince your management teams and supervisory boards that a bold move during a period of caution makes sense.
Rethink your business models.
Downturns can be a time of wrenching transformation for companies and industries. The economics of the business may change because of increased competition, changing input costs, government intervention, or new trade policies. New competitors and business models may emerge as companies seek to increase revenue through expansion into adjacent product categories or horizontal integration. Successful companies will anticipate these changes to the industry landscape and adapt their business models ahead of the competition to protect the existing business and to gain advantage.
Consider IBM. During the U.S. recession of the early 1990s, the company under Lou Gerstner faced its first decline in revenue since 1940 and endured successive years of record losses. In this context, it began to rethink its business model. Struggling with sluggish economic growth, particularly in Europe and Japan, as well as increased price competition, IBM was forced to confront head on the inevitable decline of its traditional business, mainframe computers. Realizing that the company’s markets were shifting, Gerstner redefined the company’s business model, transforming IBM from a hardware producer into a computer services and solutions provider.
Where Do You Take Action?
The process we have laid out should yield a list of promising initiatives–undoubtedly more of them than you’ll have the capacity to launch and manage all at once. So you’ll need to prioritize, carefully assessing each initiative based on several criteria–most notably, urgency, overall financial impact, barriers to implementation, and risks that the initiative might pose for the business. The result will be a portfolio of actions with the right blend of short-term and long-term focus.
Who is going to carry out the recession plan? We recommend that you form a dedicated crisis management team to manage your organization’s response to the recession. The team will develop different economic scenarios and determine how they might affect the business; identify recession-related risks and opportunities; and prioritize initiatives designed to mitigate the risks and capitalize on the opportunities. It will then oversee implementation of the initiatives, monitoring their progress and continually reevaluating them in the light of changes in the economic landscape. (For a summary of how the crisis management team can help ensure a recession plan’s success, see the sidebar “Avoiding the Snags of Implementation.”)
Companies adopting the comprehensive approach we have laid out will be not only better placed to weather the current storm but also primed to seize the opportunities emerging from the turbulence and to get a head start on the competition as the dark clouds begin to disperse.
Idea in Brief
•Many companies fail to see the opportunities hidden in economic downturns.
•To take advantage of opportunities, you first need to do a thorough but rapid assessment of your own vulnerabilities and then move decisively to minimize them.
•This will position you to seize future sources of competitive advantage, whether from bold investments in product development or transformative acquisitions.
Idea in Practice
Before trying to capitalize on the opportunities presented by a recession, you must assess and minimize your firm’s vulnerabilities. The authors suggest setting up a recession checklist.
Liquidity is the key to surviving and thriving in tough times, when both cash to meet current obligations and capital for investing in the future are scarce. So you need to…
Monitor and maximize your cash position
•Calculate expected cash inflows and outflows
•Produce a rolling weekly or monthly cash report
•Centralize or pool cash across units
Tightly manage customer credit
•Segment customers based on their credit risk
•Offer financing only to credit-worthy or strategic customers
•Assess trade-offs between credit risks and marginal sales
Aggressively manage working capital
•Reduce inventories by monitoring production and sourcing
•Reduce receivables by actively managing customer credit
Optimize your financial structure
•Reduce debt and other liabilities
•Secure access to lines of credit
•Secure access to equity capital by tapping nonmarket sources such as sovereign wealth funds
A strong market valuation relative to rivals is important in raising capital and acting on acquisition opportunities. So you need to…
•Inform investors and analysts of your recession preparedness
•Consider opting for dividend payments rather than share buybacks
Loosely run operations, sluggish unit sales, and an overextended enterprise leave you vulnerable to economic shocks. So you need to…
Reduce costs and increase efficiency
•Root out long-standing activities that add little business value
•Revive earlier efficiency initiatives too controversial to fully implement in better times
•Consolidate or centralize key functions
•Analyze current suppliers and procurement practices
•Reexamine the economics of offshoring
Aggressively manage the top line
•Revitalize customer retention initiatives
•Realign sales force utilization and incentives to generate additional short-term revenue
•Reallocate marketing spending toward immediate revenue generation
•Consider more-generous financial terms for customers in return for higher prices
Rethink your product mix and pricing strategies
•Offer lower-price versions of existing products
•Identify products for which customers are still willing to pay full price
•Consider creative strategies such as results-based or subscription pricing
•Unbundle services and adopt à la carte pricing
Rein in planned investments and sell assets
•Establish stringent capital allocation guidelines
•Shed unproductive assets that were difficult to dispose of in good times
•Divest noncore businesses
Avoiding the Snags of Implementation
One key to the success of downturn-related initiatives is rapid implementation. A formal crisis management team to oversee your company’s response to the recession can help the organization avoid these typical sources of failure.
Insufficient understanding and appreciation of the evolving crisis. The crisis management team can help create and maintain a sense of urgency within the organization, in part by creating a transparent, consistent, and fact-based process for carrying out the necessary initiatives. The team should also continually monitor the economic situation and, if needed, move from, say, a modest downturn scenario to a worst-case action plan.
Senior leaders’ lack of preparation and commitment. By promoting a close working relationship with the sponsor of the company’s recession response (often the CEO), the team can keep the company’s senior executives informed of progress and direct them to where their participation is needed.
Failure to see how individual initiatives are part of a comprehensive plan. By establishing the priority and timing of initiatives, the team can help ensure that the individual measures reinforce one another. The team should continually evaluate initiatives both individually and collectively, with the aim of suspending, accelerating, or combining existing efforts–or initiating new ones.
Lack of attention to the human element. To earn employees’ commitment to the initiatives, the team must articulate the threats facing the organization, explain why change is needed and what it will entail, and clearly communicate to individuals how they will be affected.